On January 13, 2020, Governor Murphy signed the Pass-Through Business Alternative Income Tax Act (the “Act”) into law. As a result of the Act, New Jersey pass-through entities can elect to pay an entity-level tax on New Jersey Source income. The Act provides New Jersey tax credits for the owners of electing pass-through entities equal to each owner’s proportionate share of the entity-level tax paid to New Jersey. The Act is intended as a work-around to the $10,000 limitation on the Federal Income Tax deduction for state, local and property taxes (the “SALT Limitation”), which applies to individuals.
The Act is a result of New Jersey’s opposition to the SALT Limitation made applicable by the Tax Cuts and Jobs Act of 2017 (the “TCJA”). The SALT Limitation prevents individual taxpayers who itemize their deductions on their Federal Income Tax Returns from claiming more than $10,000 in deductions for state and local taxes and property taxes. Many taxpayers have been adversely affected by the SALT Limitation, including, notably, New Jersey residents with high property taxes, which, when combined with their New Jersey Gross Income Tax, well exceeds the $10,000 cap resulting in the loss of Federal Income Tax deductions that were previously available.
For purposes of the Act, pass-through entities (“PTEs”) are business entities that are treated as partnerships or S-Corporations for Federal Income Tax purposes. A multi-member limited liability company is classified as a partnership for tax purposes unless it elects to be treated as a C-Corporation or an S-Corporation. PTEs generally do not pay tax on the income they derive. Instead, tax items of the PTE flow through to the owners who then report such items on their individual tax returns. For residents of New Jersey who own PTEs, this has always resulted in significant New Jersey Gross Income Tax being paid; however, until 2018, when the TCJA became effective, the New Jersey Gross Income Tax paid had been fully deductible on Schedule A of the Federal Individual Income Tax Return for those who itemize deductions.
The SALT Limitation is only applicable to individual income taxpayers and is therefore inapplicable to business taxpayers. As PTEs generally do not pay tax, the Act is intended to permit owners of PTEs to make an optional election to pay New Jersey Gross Income Tax on certain business income at the PTE level. An owner of an electing PTE must include the owner’s full distributive share of income on such owner’s New Jersey Gross Income Tax Return; however, the owner will receive a credit against New Jersey Gross Income Tax equal to the owner’s pro rata share of the tax paid to New Jersey by the PTE.
PTEs that elect to pay the New Jersey Gross Income Tax will claim a deduction on the PTE’s Federal Income Tax Return for the total amount of New Jersey Gross Income Tax paid, without reduction as the SALT Limitation does not apply to business taxes paid. The result is that the full amount of state income tax has been deducted against business income, which reduces the amount of business income that will flow through to each owner of the PTE on Form K-1 to the PTE’s Federal Income Tax Return.
The election to pay the entity-level tax to New Jersey is available upon the unanimous consent of all PTE members or by any officer, manager or member who is authorized to make the election on behalf of the PTE pursuant to the entity’s organizational documents. The election must be made annually on or before the due date of the PTE’s New Jersey Gross Income Tax Return. The election may not be made retroactively. An electing PTE must file a New Jersey entity tax return by the 15th day of the third month following the close of the entity’s taxable year, which is March 15th for calendar year taxpayers.
An electing PTE must pay tax on the aggregate of each owner’s share of distributable proceeds of the PTE for the taxable year, which are defined to include the net income, dividends, royalties, interest, rents guaranteed payments and gains of a PTE derived from or connected with New Jersey sources.
An electing PTE pays tax based upon the following rate schedule:
Amount of Total Distributable Proceeds – Tax
Not above $250,000 – 5.675% of Total Distributable Proceeds
$250,001 to $1,000,000 – $14,187.50 plus 6.52% on the excess over $250,000
$1,000,001 to $5,000,000 – $63,087.59 plus 9.12% of the excess over $1,000,000
Over $5,000,000 – $427,887.50 plus 10.9% of the excess over $5,000,000
The election made available by the Act is worth considering for certain owners of eligible PTEs which generate significant income sourced to New Jersey and who are currently losing Federal Income Tax deductions due to the SALT Limitation. However, it is currently unclear how the IRS will view any Federal deduction claimed for optional PTE taxes paid to New Jersey.
New Jersey previously established a separate “work-around” to the SALT Limitation based upon the Federal Income Tax deduction for charitable contributions, which is not affected by the SALT Limitation. Under that program, individuals would receive property tax credits in exchange for contributions made to certain government funds. The IRS issued regulations prohibiting the deductibility of such contributions, except in limited circumstances where the receipt of tax credits is relatively de minimis.
It would presumably be easy for the IRS to use its extensive technology to identify partnership and S-corporation tax returns which now claim a deduction for taxes paid to New Jersey as a result of this election. Therefore, taxpayers’ comfortability with the potential for an increased audit risk might be one of the many factors to be considered before making the election.